VICOM Limited Target Price: 5.45 SGD (-14.00%)

1st February 2015

Last Closed Price: 6.35 SGD 12M Target: 5.45 SGD BUMPY ROAD AHEAD

De-registration of Old Cars; Influx of New Cars As vehicles of older age is mandated by the Road Traffic Act to undergo inspection and tests more regularly, VICOM will naturally receive a higher turnover in their vehicle inspection unit. Between 2007 and 2009, COE prices across all categories of cars were at a low price. During that period, there was a huge surge in car population and as these cars age to 10 years old in the coming few years, more car owners will seek to scrap their old cars to buy new ones. This will result in relatively young car population with 30% of the cars being of less than 3 years old which does not require any form of inspection. Therefore, we think that revenue for vehicle inspection and testing segment is likely to come under pressure. Gloomy Outlook for Construction and Oil & Gas Sectors VICOM derives a large part of its revenue from non-vehicle inspection and testing segment in which has enjoyed a good growth largely attributed by the buoyant Singapore construction sector in the past few years as well as oil and gas sector that has benefited from oil prices trading over 100USD per barrel in the past few years. However, we start to see a slowdown in the local construction and oil and gas sector due to numerous property cooling measure and the recent collapse of oil price respectively. Therefore, we expect a slowdown in growth or even a decline in revenue for its non-vehicle inspection and testing segment. Lack of Transparency Being a company in a mature industry with stable cash flow and trading at a premium to its book value, VICOM has surprisingly failed to be transparent about its earnings for its non vehicle inspection and testing segment. This adds on uncertainty in our projection as we are unable to be sure what are the weights of construction and oil and gas sectors have on this segment of revenue. Furthermore, looking at how this segment contributes a larger portion of revenue to the company but yet yields the almost similar net income as the vehicle inspection and testing unit sheds light that this is not a segment with high operating margin. Valuation and Key Risks We have employed Discounted Cash Flow valuation by means of Free Cash Flow to Equity (FCFE) because of the company’s strong operating cash flow and minimal debt. Assuming an 8% cost of equity and a long term growth rate of 2% for a DCF period from 2014 to 2018. This gives us a DCF value of $5.45 and a potential downside of 14% after applying 20% margin of safety. Key risks are changes in Traffic Road Act regulations and policies.

Downside Potential: 14.00% GICS Sector: Industrial GICS Sub-Industry: Diversified Support Service

Bloomberg Ticker VCM SP Equity 1Y Price v. Relative Index

Company Description VICOM Ltd is Singapore's leading provider in technical testing and inspection services. Since then, the company has expanded to provide a comprehensive range of inspection and testing services in fields including mechanical, biochemical, civil engineering and non-destructive testing, in both Singapore and the region. VICOM constantly stays on the cutting edge of testing and inspection technology.

Key Financials Market Capitalization (mil SGD) 562.75 Shares Outstanding (mil) 88.622 A.D. Value Traded (mil SGD) 0.414 Free Float (%) 85 Dividend Yield (%) 2.53 Beta 0.422 P/E (ttm) 19.78

(USD mil) FY11A FY12A FY13A FY14A P/E (x) 12.57 16.33 15.23 - P/B (x) 3.01 3.70 3.36 - ROE (%) 25.42 23.79 23.16 - 12m Gross Div 0.14 0.15 0.16 - Div Yield (%) 3.99 3.07 3.16 - D/E 25.42 23.79 23.16 - EBITDA 35.23 37.52 39.92 - EPS (USD) 0.29 0.30 0.32 - Key Executives Chairman Limt Jit Poh Deputy Chairman Kua Hong Pak CEO / Director Sim Wing Yew Non Executive Director Sim Cheok Lim Research Analyst: Lester Koh lesterkoh92@gmail.com Toh Zhen Zhou zhen.zhou@hotmail.com

-0.2

-0.1

0

0.1

VICOM SP EQUITY STI INDEX

Figure 1. Revenue by Division

Company Overview

VICOM Ltd provides motor vehicle evaluation and other related services in Singapore. It offers vehicle inspection services, vehicle assessment services, commercial and industrial testing, emission test and laboratory services, as well as motor insurance services. The company also provides non-vehicle testing inspection as well as consultancy services. In addition, it also offers other services such as car evaluation, vehicle inspection and type approval systems, in-vehicle unit services, speed limiter checks, road tax renewals, chassis dynamometer smoke tests, tinted glass checks, consultancy and business opportunity services. The company was incorporated in 1981, is based in Singapore and is a subsidiary of ComfortDelGro Corporation Limited VICOM’s revenue can be broken down into 3 main segments. Inspection and Testing services comprise the bulk of revenue, at 96% as of 2013, followed by 3% and 1% for Rental Income and Other Income respectively as shown in Figure 1. VICOM also has a wholly owned subsidiary, SETSCO, which carries not non-vehicle related inspection and compliance services. SETSCO is accredited to certified concrete and fire safety products. And as of 2010, has a 5% market share in concrete certification. SETSCO is the sole provider of inspection services in the Pressure Vessels and Lifting Equipment category for air receiver, tank and chain block. Air receivers are pressure tanks commonly employed in the marine, oil and gas industry. SETSCO also participates in the building construction and maintenance inspection, where competition is slightly lesser with around 2-3 competitors in each of its accredited inspection area. Inspection is a recurring income as under the Building Control Act, a building that is not solely used for residential purposes will need to be inspected every 5 years from the date of TOP and 10 years for residential building. SETSCO also participates in structural fixing testing, calibration and measurement, non-destructive testing, mechanical engineering, as well as the testing of chemical products.

Figure 2: Shareholders Structure

Source: VICOM Annual Report 2013

Figure 3: Insider Trades

Date Name Lots

20-11-14 Sim Cheok Lim 17

14-11-14 Sim Cheok Lim 3

29-12-11 Heng Chye Kiou 280

26-07-10 Heng Chye Kiou 80

30-04-10 Heng Chye Kiou 80

19-01-10 Ho Kah Leong 6

Source: www.shareinvestor.com

VICOM has a limited amount of free float due to a majority stake owned by ComfortDelGro which owns 68% of the company. The next top 19 largest shareholders make up 17% ownership of the company, while the remaining 15% is owned by individual investors as shown in Figure 2. Besides ComfortDelGro, other significant owners include Raffles Nominees at 3.8% ownership, HSBC Nominees at 2.09%, Quah Wee Lai at 1.70%, and DBS Nominees at 1.68%. The free float of 15% for individual shareholders implies that VICOM is an extremely illiquid stock. On top of that, VICOM only has 88.625 million outstanding shares. Due to the nature of illiquidity, VICOM’s share price often dislocates from its intrinsic value. Furthermore, shareholders of VICOM are This is likely to be so considering that the last sale of shares by Director Heng Chye Kiou was in February 2012 at the price of $4.07. Recently, Director Sim Cheok Lim bought a total of 20 lots worth of shares from 18-21 November 2014. Furthermore, Insider Traders have been mostly on the buy side, with Heng Chye Kiou’s sale of shares being the only Insider Sales since 2005. This implies a strong willingness from insiders to hold VICOM shares in the long run, which may present a risk to our sell thesis. VICOM’s capital structure consists of 100% Equity. Its equity attributable to shareholders of the Company comprises issued capital, reserves and retained earnings.

96%

3% 1%

Inspection and Testing Services Rental Income Other Income

17% 67%

15%

ComfortDelGro Next Top 19 Investors Retail Investors

Figure 4: Inspection Frequency for Different Vehicles

Frequency

Age of the Vehicle

<3 years 3-10 years

>10 years

Motorcycles & scooters

Nil Annually Annually

Cars Nil Biennially Annually

Tuition cars Annually Annually Annually

Private hire Nil Biennially Annually

Taxis 6-mthly 6-mthly NA

Public buses

6-mthly 6-mthly 6-mthly

Other buses Annually Annually 6-mthly

Light goods vehicles

Annually Annually 6-mthly

Heavy goods vehicles

Annually Annually 6-mthly

Buses Annually Annually 6-mthly

Trailers Annually Annually Annually

Source: www.vicom.com.sg Figure 5: Porter’s 5 Forces

Source: Team Estimates

Industry & Competitive Analysis

VICOM’s main service, Vehicle Inspection and Testing, remains an effective monopoly in the local market with up to 8 local inspection centres. This currently gives it a strong economic moat due to the high barriers to entry. VICOM not only has its network of centres strategically placed across Singapore to capture market share, its superior brand recognition and experience in the market has allowed it to further exploit its competitive advantage. While VICOM cannibalizes most of the market share, there are still some competitors in market such as STA and JIC. However, VICOM owns 70% of JIC which effectively reduces their competitor down to STA. The Vehicle Inspection industry is also largely affected by the policies in place under the Road Traffic Act which requires vehicles to undergo inspection regularly to ensure its functionality on the road as shown on Figure 4. This will therefore, directly affect VICOM’s revenue in this segment greatly if there were to be any changes in such regulation. Insofar, we have seen COE growth tapered down from 3% to 0.5 %. We did a simple Porter’s 5 Forces Analysis as shown in Figure 5. VICOM’s Other Services fall within global testing, inspection and certification (TIC Industry), this industry covers all sectors and is served by many specialised and independent agencies such as SGS and Bureau Veritas. The market still remains highly fragmented with few global players operating in different multiple sectors. The industry continues to consolidate with large players like SGS aiming to consolidate their capabilities and increase their presence. While this industry tends to decouple from traditional macro indicators such as GDP, it still retains a minor cyclical dimension. The industry is also characterised by high barriers to entry owing to the need of an international network, extensive expertise as well as the requirement of accreditation from the government before such services can be provided. SETSCO has a very strong competitive edge in the local TIC industry with the closest competitor being TUV SUD which is one of the 8 largest TIC Corporations. SETSCO’s strength lies in it having the most number of accreditations in the whole range of services. Revenue patterns remain generally predictable albeit a minor cyclical dimension as Inspection and Testing is often required regularly and are also based on recurring contracts. Customer loyalty also tends to be high as it may be costly and time consuming to switch between such service providers, and even more so in specialized cases that can only be delivered by a few certification companies. This high switching cost can be rationalised by the large amount of time and cost needed for the first certification cycle as compared to subsequent ones which may take up less time and cost as it is recurring and knowledge of existing processes and issues are already present. That being said, the specialized nature of inspection and testing also means that expansion across different sectors is generally difficult, thus making acquiring market share in the entire industry difficult as well.

From a macroeconomic perspective, globalisation has enhanced the need to ensure quality and reliability of goods. Furthermore, we see protectionism via standards and testing as potential ‘weapons’ that can be used by countries to avoid imports. This implies a long term increase for standards, inspection, and testing services. A main source of growth in the industry will be a movement towards tighter regulation, better quality control, more inspection and monitoring demanded by customers to ensure safe products that are reliable and up to

0 1 2 3 4

Threat of New

Entrants

Bargaining Power of Buyers

Threat of Substitute Products

Competition in the Industry

Bargaining Power of Suppliers

health, safety and environmental standards. As such, events such as the recalling of faulty cars, as well as building structure failures, among others, have a positive effect on the industry.

Figure 6: Age Distribution of Car Population

Age (Years)

Cars Number %

0 - < 1 28,547 4.6% 1 - < 2 21,943 3.6% 2 - < 3 27,288 4.4% 3 - < 4 27,727 4.5% 4 - < 5 41,402 6.7% 5 - < 6 68,460 11.1% 6 - < 7 96,674 15.7% 7 - < 8 105,216 17.1% 8 - < 9 113,962 18.5%

9 - < 10 73,764 12.0% 10 - < 11 1,840 0.1% 11 - < 12 614 0.1% 12 - < 13 357 0.1% 13 - < 14 567 0.1% 14 - < 15 533 0.1% 15 - < 16 443 0.1% 16 - < 17 477 0.1% 17 - < 18 414 0.2% 18 - < 19 980 0.1% 19 - < 20 451 0.8%

20 & Above 4,950 0.8% Total 616,609 100%

Source: www.lta.gov.sg

Investment Thesis

De-registration of Old Cars; Influx of New Cars As mentioned, above under industry analysis, under Singapore’s Road Traffic Act, vehicles are mandated to undergo inspection to ensure their safety and functionality. In general, as vehicles age, they are required to go for inspection more regularly. For example, cars of age 0 to 3 years old are not required to go for inspection as compared to cars of age 10 years old and above which are mandated to go for inspection annually. Therefore, it is clear that VICOM’s vehicular inspection revenue will increase in tandem with the number of old vehicles in the vehicular population. Conversely, if the car population were to renew, VICOM’s revenue will be negatively impacted. We find that the latter situation is likely to occur in the coming few years. Referring to Figure 6, we find that car population facing an aging population whereby 46.8% of the car population are of 7 to 10 years old. This can benefit VICOM if most of these cars cross over the 10 year mark which will require them to be inspected annually as shown in Figure 6. However, the life time of a Certification of Entitlement (COE) lasts for 10 years and as expiry draws closer, owners are given a choice to extend their COE by another 5 or 10 years or scrap their car. If car owners opt to extend their COE, their COE price will calculated by the moving average of the past 3 months’ COE price. Despite having such a policy in place, if we were to observe the trend in the number of cars beyond 10 years old, it is clear that most car owners opt to scrap their cars. On top of that, with the bulk of the cars expiring in the coming 3 years, the supply of COE available will likely cause COE price to ease and thereby, incurring a feedback loop that will encourage more people to scrap their car at the 8th, 9th or last year of their COE. As such, Vehicle Inspection and Testing segment’s revenue will likely come under pressure as the bulk of old vehicles will be replaced with new ones which do not require any inspection for 3 years. The drop in old vehicles is likely to be around 30% to 40% in the next 3 years which may possible translate to a fall in revenue of about 2% to 7% each year for the next three years. Gloomy Outlook for Construction and Oil & Gas Sectors VICOM derives a large part of their revenue from their non-vehicular inspection and testing segment. On top of that, the management does not reveal the breakdown of the revenue from this segment. Hence, it is unclear how much of this unit’s revenue is contributed by construction or oil and gas sector respectively. However, within the annual report of 2013, the growth in revenue contributed by this segment is said to be generally attributed by the buoyant construction sector in Singapore and global oil and gas sector. Therefore, it is logical to deduce that revenue in this segment is highly susceptible to growth of construction and oil and gas sector. With the recent oil price collapse due to the OPEC refraining to cut back oil production and U.S. shale production breaking new highs, oil and gas sector has been suffering a huge decline in profitability as low oil price has reduced margins and deep sea drilling is no longer profitable. This has caused oil rigs all over the world to decline at an alarming rate as shown in Figure 6. In turn, VICOM’s non-vehicle revenue will be affected as much fewer rigs will be built and maintained and therefore, less testing and inspection is required.

Adding oil to the fire is the cooling property market in Singapore. With HDB building aggressively to meet the high demand in the past few years along with numerous property cooling measures implemented, we expect a likely slowdown or even decline in the local construction sector. This can be seen from the fact that there has been a decline in HDB Resale Index from Figure 7, suggesting that there has been a large supply of HDB in the past few years. Hence, it is likely that HDB will be slowing their pace of HDB construction. Therefore, the same logic applies, such that with fewer house expected to be built over the next few years, revenue growth will be hard to maintain. Considering the situation in oil and gas sector currently, the possibility of a decline in revenue and profitability is absolutely possible.

Figure 7: Change in HDB Resale Index

Source: www.hdb.gov.sg

Taking the current situation coupled with slowing growth the next few years, we are generally pessimistic on the ability of the non-vehicle and testing segment to generate revenue levels that are worthy of current valuations. Lack of Transparency For a mature company like VICOM with such stable cash flow, consistent dividend and minimal debt, investors will usually assume that the company has high visibility for future cash flows and thereby, attracting investors to pay a premium for such quality and stable company. However, contrary to such common belief, VICOM has opt to divulge less information in regards to its business segments by merging revenue contributed from both the non-vehicle and vehicle inspection and testing segments. Vehicle inspection and testing segment has high visibility and predictability in future revenue as information of vehicle population, age and other relevant statistics are readily available on LTA’s website. However, for VICOM’s non-vehicle segment, information has already been limited in 2011 Annual Report prior to the merge. With the merge now, revenue visibility is shrouded even further breeding uncertainty in a quality stable company. We think that with such uncertainty and slightly poor corporate governance, the company should not be trading at an extremely high premium, thereby suggesting that VICOM can possibly be overvalued.

-6.00%

-4.00%

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

2005 2007 2010 2012

% Change from Previous Quarter

Valuation & Key Investment Risks

We employ a DCF valuation for VICOM after considering the company’s high stability of cash flows We assume a discount rate of 8% derived from STI’s historical returns for our DCF valuation. As an added precaution, we employ a small margin of safety of 20% over our valuation. This gives us a valuation of $5.45.

Figure 9: Sensitivity of target price to Non-vehicle segment growth

Target Price

No

n-v

eh

icle

se

gm

en

t g

row

th

1% $ 3.70

2% $ 3.90

3% $ 4.11

4% $ 4.33

5% $ 4.56

6% $ 4.80

7% $ 5.05

8% $ 5.31 Source: Team Estimates Figure 10: Sensitivity of target price to Growth of car population

Target Price

Gro

wth

of

Ca

r p

op

ula

tio

n

0.5% $ 4.32

1.0% $ 4.32

1.5% $ 4.32

2.0% $ 4.33

2.5% $ 4.33

3.0% $ 4.33

3.5% $ 4.33 Source: Team Estimates

DCF Valuation: Discounted Cash Flow Model: Free Cash Flow to Equity (FCFE) – This method is applicable considering the company’s current capital structure which is 100% equity. We assumed an 8% Cost of Equity and a long term growth rate of 2% for a DCF period from 2014 to 2018. This gives us a DCF value of $5.45 and a potential downside of 14%.

Figure 8: Sensitivity analysis of DCF Valuation Without Margin of Safety

Long Term Growth Rate

1% 2% 3% 4%

Cost of Equity

5% $6.86 $8.82 $12.74 $24.51

6% $5.53 $6.68 $8.58 $12.40

7% $4.65 $5.39 $6.51 $8.36

8% $4.02 $4.54 $5.26 $6.34

9% $3.55 $3.93 $4.43 $5.13

10% $3.19 $3.47 $3.84 $4.32

Figure 11: Sensitivity Analysis of different factors on Valuation

Revenue Assumptions: For revenue coming from local vehicle inspection and testing, we utilised Singapore’s age distribution chart, and projected the potential deregistration of COEs upon reaching the tenth year for all vehicle types. Vehicles aged 3 to 10 years old are to be inspected biennially while vehicles aged 10 and above are subjected to annual inspections. Taking this, as well as the cost per inspection into consideration, we projected the base income from vehicle inspections and added a 37% premium to account for additional vehicle services rendered. With regards to the non-vehicle testing an inspection segment, which contributes the majority of VICOM’s revenue, we assume a GDP-Plus estimate of 4% for our revenue growth from this segment. Conditional Drivers of additional upside The following potential events may invalidate our sell thesis and provide upside movement for VICOM:

$3.00 $4.00 $5.00 $6.00 $7.00 $8.00 $9.00

Non-vehicle segment

Car population growth

LT Growth

Cost of Equity

Valuation Range

Sensitivity Analysis

Macro potential events: An increase in Singapore’s GDP growth might increase car ownership (if COE supply does increase in tandem). This may increase VICOM’s revenue. An improvement in the global macroeconomic outlook may improve revenues from inspection and testing as companies and property developers roll out new products and projects which require SETSCO’s inspection and testing services. Industry potential events COE Prices which have a direct impact on car prices will affect and determine the amount of upside VICOM can attain. From 2015 to 2016, approximately 225000 COEs will reach 10 years and are likely to expire. Projecting forward, this would imply a surge in cars above 3 years old in 2018-2019 as a large number of new COEs reach 3 years and their cars require regular inspection. We thus expect a drop in revenue after 2016 before recovery in 2018, leading to subsequent potential upside. This is contingent on LTA issuing the same or higher number of COEs from 2015 to 2016 as the older ones expires. Should LTA decrease the number of COEs issued by a large amount, COE prices would increase, and this may imply higher revenues for VICOM as consumers stick to older cars which require more inspection and testing. Other drivers include a potential increase in supply of residential property i.e. HDB flat supply, as well as other construction related developments, which may allow SETSCO to secure large contracts, providing more upside. Company potential events: As mentioned earlier, any significant additional upside will be dependent on VICOM’s ability to acquire and develop new core competencies in Inspection and Testing in other sectors. Conclusion To conclude, we issue a SELL recommendation for VICOM as despite strong long term economic moats and fundamentals, the sustainability of its revenue growth for the next few years remains questionable, and we feel that the market has yet to fully price in these pessimistic events. Our valuation of VICOM also shows that the company is quite overvalued even with a 20% margin of safety at $5.45. Even our optimistic assumptions from the non-vehicle segment, which contributes the majority of VICOM’s revenues, fail to reach the current price. Thus we reiterate our sell call with a 1 year target price of $5.45.

$5.31

$4.33

$3.70

$-

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

7/6/2009 11/18/2010 4/1/2012 8/14/2013 12/27/2014 5/10/2016

Figure 13: VICOM Valuation

This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part

without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in

part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific

recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this

publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it

without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not

given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the

recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising

whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to

seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives,

financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information

purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial

instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the

information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any

opinions expressed in this research material are subject to change without notice.

©2015 NUS Invest